Morning Market Thoughts

Good morning. The market is set to open higher this morning and it looks like the rally will continue. As I noted yesterday, while virtually all indexes are hitting new highs (SP-500, Dow-30, Dow-20, Nasdaq Composite, S&P 400 MidCap Index, and Russell 2000 SmallCap Index), the momentum does not resemble the type of parabolic move that sucks the last of the bears into the market in one last gasp of buying activity. These types of parabolic moves can occur on individual stocks because the buying is concentrated — money piles into that specific stock for various reasons. At some point, the aggressive buying runs its course. Suddenly, demand completely dries up. Like Icarus who flew too close to the sun on wax wings, the lift goes away and gravity takes over. Put another way, when bids are few, offers are many. (Think Ambarella (AMBA) in July of 2015, where a steep move to $130 led to a 70% reversal that took the stock down to the mid-$30’s over the next several months.)

But it’s very rare to see the entire equity market make such a move because of the thousands of stocks and ETFs that attract money. Currently, there is still a lot of bearish sentiment out there. One of my favorite sentiment indicators is the “Smart Money / Dumb Money Confidence” indicator, a proprietary indicator originated by Jason Goepfert at SentimenTrader.com. The Smart/Dumb indicator reflects what the “good” market timers are doing compared to what the “bad” market timers are doing. Where there are a few opinions in the calculation, most of the components are real-money gauges. Not “what do people think?” Rather, “what are people doing?” It takes into account such things as the OEX put/call and open interest ratio; money flow into/out of Rydex mutual funds and small speculators in equity index futures contracts. Put another way, the index compares what the emotional money is doing relative to the rational money.

Its real usefulness is at extreme dislocations between the smart money and the dumb money. When “dumb money” is extremely bullish, and “smart money” is extremely bearish, the market is ripe for a reversal simply because bearish smart money equates to lots of cash looking for an excuse to buy–but not yet finding a reason–and dumb money is fully invested. Retail investors are “all in”, and are now cheerleaders.

When retail traders are all-in, and professional traders are mostly out, it’s inevitable that we’re at a market top.

That’s just not the case now. While “dumb money” is more optimistic than “smart money”, there is just not much difference between the two indicators. And when the difference is small, the prevailing uptrend tends to continue. Think of it this way: There’s a party going on in the market, and it’s fun to be there. But nobody is hanging from the chandeliers or jumping in the pool fully clothed with a cocktail in their hand.

But with that said, and I hate to be a buzz kill, the MidCap and SmallCap indexes have made very fast and steep advances since the August lows. So it wouldn’t surprise me to see stocks take a rest sometime soon as this round of buying runs its course.

If we do see this type of pullback in the market, I think it’ll lead to a buying opportunity.

My suggestion: Focus only on those stocks that are in sustainable uptrends or are taking a breather on light volume, and consider putting a portion of your cash in the S&P 500 ETF (SPY). It’s then easier to maintain broad market exposure while concentrating your attention on fewer stocks.